1/26/12

What is a giffen good, an example with graphs



In economics, a giffen good is an inferior good with the unique characteristic that an increase in price actually increases the quantity of the good that is demanded.  This provides the unusual result of an upward sloping demand curve.

This happens because of the interactions of the income and substitution effects.  Depending on whether the good is inferior or normal, the income effect can be positive or negative as the price of a good increases.  Imagine an inferior good being Top Ramen (an inexpensive noodle dish, common among students).  As your income rises, you actually consume less Top Ramen, because you may begin to buy more spaghetti, or steak, or something you enjoy more than Top Ramen.  But if you lose your job, and your income goes down, you will consume more Top Ramen, because it is inexpensive.

Next we have to consider the substitution effect.  No matter type of good, the substitution effect will be negative as the price of that good goes up.  So if the price of Top Ramen rises, the substitution effect will dictate that you will buy more spaghetti, or steak because that good has become relatively cheaper.

The interesting thing about a giffen good, is that when the price of a giffen good rises, the income effect is greater than the substitution effect.  So if a good is inferior, the income effect will be positive and larger than the negative value from the substitution effect.

Summary:  if a good is inferior, a drop in income (represented by a price increase) increases the quantity of the good that is demanded.  The substitution effect is negative for any good that experiences a price increase.  A giffen good faces an upward sloping demand curve because the income effect dominates the substitution effect, meaning that quantity demanded increases as price rises.



However, a good cannot have an upward sloping demand curve forever, because eventually the consumer will run out of money.  Remember that giffen goods have to be inferior goods, which implies that the consumer purchasing them has little money to begin with.  At some point, the rising price of the giffen good takes over the consumer’s entire budget, and a price increase will actually lower the amount of the good the consumer is able to buy.  This means that at high enough prices, we will see the traditional downward sloping demand curve.

Let’s go through an example of a giffen good, using potatoes and steak as the choice set of the consumer.  Imagine the consumer has a budget of $30, and the cost of a potato begins at $0.50 and the price of a steak is $10.00.  Also consider that the consumer needs to buy meals for 10 days.

With the original budget and prices, the consumer may choose to consume 2 steaks, at $20, and 20 potatoes for $10 over this time frame to use up their entire budget.  This is a satisfactory amount because they will have on average 2 potatoes a day, and 2 steaks over the period.

Now imagine a price increase of potatoes to $1 each.  The consumer could still buy 2 steaks, but could now only buy 10 potatoes.  This might leave them hungry, so it is possible they will buy less steak, and more potatoes in order to get their calories.  This means that 20 potatoes will still be purchased, but now only 1 steak is purchased.

If the price of a potato increased again, say to $1.25, then the consumer would only be able to get 16 potatoes for $20, which may not be enough calories to survive.  They will decrease their steak consumption by one, and use that money to buy more potatoes in order to get the necessary energy.  In this example, potato consumption would rise to 24 ($30/$1.25) and steak consumption would drop to zero.  This shows how consumption of a good would rise with a price increase (thus an upward sloping demand curve).

At this point, the consumer’s entire budget is taken up by the giffen good, so any price increase now will result in a decrease of the amount of good the consumer is able to buy.  Thus, we will have our typical downward sloping demand curve.



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1 comments:

cp on July 21, 2014 at 10:37 AM said...

Thank You.

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